Consistently, management's explanations of corporate performance in accounting narratives have been found to suffer from self-serving bias. Yet there is no unequivocal evidence as to whether this bias is the product of conscious efforts to manage the impressions of the audience or the result of unintentional cognitive biases. The present study contributes to this discussion by comparing the narratives of the letters addressed to shareholders of Europe's most highly-capitalized companies in crisis and non-crisis settings. We find that a crisis situation leads to more extensive use of self-serving bias as adverse external economic conditions are used by managers to present themselves in the best possible light. Given that the letters to shareholders are widely used for capital allocation decisions and considering the evidence that intentional self-serving behavior can be successful, our results imply that investors need to be alert to misleading explanations of performance, particularly during external crises. The International Accounting Standards Board (IASB) has formulated a practice statement proposing non-mandatory guidance on the management commentary that accompanies financial statements. Our results suggest that the quality of narrative information in annual reports is unlikely to be augmented by guidelines that encourage the discussion of corporate performance through the eyes of management.
We investigate the audit fee response to CEO behavioral integrity (BI). BI refers to the perceived congruence between an individual's words and deeds (Simons 2002). Because low word-deed congruence should result in more explanations when communicating, we use variation in explanations beyond firm fundamentals and CEO-specific characteristics in more than 30,000 shareholder letters to serve as a linguistic-based proxy for CEO BI. We find that audit fees increase as BI decreases, but BI is not associated with financial misstatement or litigation. These findings are potentially consistent with auditors undertaking additional work in response to low BI, which, in turn, mitigates the risk of restatements and lawsuits. The likelihood of option backdating increases as BI decreases, consistent with the contention that auditors lacked incentives to prevent backdating. Finally, BI is increasing in future performance, which suggests that CEOs partially underpin the returns to high-integrity corporate cultures. JEL Classifications: J24; L25; M14; M41; M42. Data Availability: Proprietary data from KRW International cannot be shared because of the terms of a confidentiality agreement. All other data are available from the public sources cited in the text.
An important milestone often reached in the life of an activist engagement is entering into a "settlement" agreement between the activist and the target's board. Using a comprehensive handcollected data set, we analyze the drivers, nature, and consequences of such settlement agreements. Settlements are more likely when the activist has a credible threat to win board seats in a proxy fight and when incumbents' reputation concerns are stronger. Consistent with incomplete contracting, face-saving benefits and private information considerations, settlements commonly do not contract directly on operational or leadership changes sought by the activist but rather on board composition changes. Settlements are accompanied by positive stock price reactions, and they are subsequently followed by changes of the type sought by activists, including CEO turnover, higher shareholder payouts, and improved operating performance. We find no evidence to support concerns that settlements enable activists to extract rents at the expense of other investors. Our analysis provides a look into the "black box" of activist engagements and contributes to understanding how activism brings about changes in target companies.
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